Chapter 10: Long-Term Liabilities Flashcards
Types of long-term liabilities (most common long-term (or non-current) liabilities)
Pension / post retirement plans Long-term loans Bonds payable Future income taxes lease liabilities
Why Are Long-Term Liabilities of Significance to Users?
It is equally important for users to have an awareness and understanding of potential liabilities such as contractual commitments or the possible outcomes of litigation against the company. These items may have significant impacts on the company’s operating results well into the future.
Transactions with Lenders
- company borrowing funds by taking out a loan or mortgage.
- Companies can also access debt funding through the issuance of notes or bonds
Companies are required to disclose the details of their long-term loans in the notes to their financial statements (such as term of loan, interest rate, and security and collateral)
long-term debt, long-term notes payable, loans payable, mortgages payable, notes payable, or bonds payable
Found on statement of financial position
mortgage loan
a long-term debt with land, a building, or a piece of equipment pledged as collateral or security for the loan.
-If failed to pay for, the lender has the right to seize the asset and sell it
Financing agreement
A lending agreement between a lender and a borrower that specifies the terms and conditions of the loan. These include loan term, interest rate, repayment provisions, and so on.
instalment loans
A type of loan in which payments (including both interest and a portion of the principal) are made periodically, rather than only at the end of the loan.
Blended payments
consisting of both interest and principal components
-The total amount of the payment is the same each period, but the portion of each payment that represents interest is reduced, as the outstanding loan principal is being repaid with each loan payment.
two basic transactions related to these debts
- Initial borrowing
2. Periodic loan payment
- Initial borrowing
At the time of borrowing, a company will simply record the receipt of the loan proceeds (the receipt of cash) and the corresponding loan liability
- NO INTEREST RECORDED AT TIME OF BORROWING
Initial borrowing accounts
Cash XXX
Long-Term Loan Payable/Mortgage Payable XXX
- Periodic loan payment
This loan payment, to be made monthly, quarterly, or in other periods, will normally include both an interest component and a principal component
Periodic loan payment accounts
Interest Expense XXX
Long-Term Loan Payable/Mortgage Payable XXX
Cash XXX
covenants
Conditions or restrictions placed on a company that borrows money. The covenants usually require the company to maintain certain minimum ratios and may restrict its ability to pay dividends.
Financial covenants
may require the company to:
- meet certain financial ratios
- may include limits on the company’s ability to borrow additional amounts
- to sell or acquire assets
- pay dividends
Non-financial covenants
may include:
- requirements to provide the lender with interim financial statements
- to have an annual audit conducted.
Bond
A corporation’s long‐term borrowing that is evidenced by a bond certificate. The borrowing is characterized by a face value, interest rate, and maturity date.
Bonds can be sold
through a public offering or through a private placement
Public offering
The offering of corporate bonds for sale to the public, both individuals and institutions
private placement
open only to specific institutional investors who have agreed to purchase the bonds in advance
institutional investors
Banks, insurance companies, pension funds, and other institutions that purchase corporate bonds or shares
indenture agreement
An agreement that accompanies the issuance of a bond and specifies all the borrowing terms and restrictions, or covenants
face value / principal amount for the bonds
A value in a bond contract that specifies the cash payment that will be made on the bond’s maturity date. The face value is also used to determine the periodic interest payments made on the bond
(usually $1,000 per bond.)
maturity date
The date in a bond contract that specifies when the principal amount borrowed must be repaid
Bond interest payments to the lenders (equation)
multiplying the bond interest rate (or contract rate or coupon rate ) by the face value and dividing by two (because the interest payments are semi-annual)
bond interest rate aka contract rate / coupon rate
An interest rate that is specified in a bond contract and used to determine the interest payments that are made on the bond
-Carefully considered, factors such as: bond term, credit rating of the issuer, special features, rates on alternative investments, and economic conditions
Effective rate (aka yield)
The interest rate that reflects the rate of return earned by investors when they purchase a bond, and the real interest cost to the issuer of the bond. It reflects the competitive market rate for similar bonds, and is used in determining the selling price of the bond.
KEY POINTS for bonds
The contract rate is used to calculate the semi-annual interest payment.
The yield is used to calculate the semi-annual interest expense.
collateral
the company pledges as security to the lenders
If collateral is pledged:
it means that if the company defaults on either the interest payments or the maturity payment, the bondholders can force the pledged assets to be sold in order to settle the debt.
debenture
A bond that is issued with no specific collateral
Debentures can be either
senior or subordinated
The distinction between senior and subordinated is
the order in which the bondholders (creditors) are paid in the event of bankruptcy: senior creditors are paid before subordinate claims
Convertible bonds
A bond that is convertible into common shares under certain conditions
investment banker
The intermediary who arranges the issuance of bonds in the public debt market on behalf of others. The investment banker sells the bonds to its clients before the bonds are traded in the open market
Underwriters
An investment bank that arranges and agrees to sell the initial issuance of bonds or other securities
Issuing bonds can be expensive:
companies generally issue bonds only when their borrowing requirements are significant, usually $100 million or more (100,000,000)
Bonds differ from loans and mortgages in a number of ways, including the following:
- Bonds are generally sold to a pool of investors (acting as lenders), whereas loans and mortgages are generally made by a single lender.
- Issuing bonds can enable a company to tap into a much larger pool of lenders than it could when entering into loans or mortgages.
- Bonds normally have much longer terms than are available with loans and mortgages. It is not unusual for bonds to have a 40-year term, which is much longer than the usual terms of loans and mortgages.
- Bonds generally require semi-annual, interest-only payments, with the principal repaid only at the end of term. Loans often require blended repayments of principal and interest, with a monthly payment frequency.
- There is a secondary market for many corporate bonds, meaning they can be purchased through investment dealers or on major exchanges. This enables lenders to sell the debt to others rather than having to wait to collect it at maturity.
- Some corporate bonds are convertible into common shares at the option of the bondholder. The conversion price is specified in the indenture agreement.
(see Exhibit 10.2)
How Are Bonds Priced in the Marketplace?
Bond prices are established in the marketplace by the economic forces of supply (from companies wanting to issue bonds) and demand (from investors wanting to buy them)
The _____ the level of risk, the _____ the yield rate has to be
higher
higher
(for buyers to accept a higher risk of default, they have to be compensated for that risk with a higher rate of return)
par
In the context of bond prices, a term used to indicate that a bond is sold or issued at its face value
(For example, if a company issued bonds with a face value of $100 million at par, then investors would have paid $100 million for them.)
The only way that an investor can increase the return (or yield) they will receive on the bond would be to
pay less than the face value of the bond
regardless of whether the investors pay less or more than the bond’s face value on issuance:
they will receive the full amount of the bond’s face value on maturity
discount
In the context of bond prices, a term used to indicate that a bond is sold or issued at an amount below its face value. (base index less than 100)
Example of discount:
For example, if the company issuing $100 million in bonds issued them at 98.4, investors would have paid $98.4 million ($100,000,000 × [98.4/100]) for them
These investors would still receive $100 million on maturity, with the $1.6-million difference being additional interest income to the investors and additional interest expense to the issuing company.
premium
In the context of bond prices, a term used to indicate that a bond is sold or issued at an amount above its face value (that is, more than 100)
Example of premium:
For example, if the company issuing $100 million in bonds issued them at 101.5, investors would have paid $101.5 million ($100,000,000 × [101.5/100]) for them.
These investors would receive only $100 million on maturity, with the $1.5-million difference reducing the interest income of the investors and the interest expense of the issuing company
(see exhibit 10.3)
notes payable refers to
both notes payable and bonds payable
Issuing bonds accounts
Cash 98,400,000
Notes Payable 98,400,000
How Does the Pricing of Bonds Affect a Company’s Interest Expense?
The contract rate will determine the amount of the cash payment that will be made to the bondholders, while the yield will determine the amount of the company’s interest expense.
amortization of the bond discount (or premium)
amortization of bond discount (or premium)
Difference between the contract rate and yield rate on bonds a company issues
The steps in accounting for each semi-annual interest payment are as follows:
- Determine the cash interest payment.
- Determine the interest expense
- Determine the amortization of the bond discount or premium.
- Determine the cash interest payment.
Interest Payment = Face Value × Contract Rate × 6/12
if semi-annual
- Determine the interest expense
Interest Expense = Carrying Value × Yield × 6/12
- Determine the amortization of the bond discount or premium.
Amortization of Discount (or Premium) = Interest Expense – Interest Payment
Why Do Companies Lease Capital Assets?
When a company needs a new capital asset, such as a piece of machinery, there are two ways it can obtain it. It can either purchase it or lease it
lessee
The party or entity that is renting or effectively purchasing the asset in a lease arrangement.
(Dad leasing from ford)
lease agreement
An agreement between a lessee and a lessor (in the case of an operating lease) for the rental of or (in the case of a finance lease) the effective purchase of an asset.
lessor
The owner of an asset that is rented or effectively sold to a lessee under a lease arrangement
Why lease an asset rather than purchase it
- It lacks the cash to be able to purchase it or it wants to use its cash for other purposes.
- It lacks the cash to be able to purchase it and is unwilling or unable to obtain a loan to finance the purchase of the asset.
- It has only a short-term need for the asset; that is, it will not need the asset for most of its useful life.
-The asset is expected to quickly become obsolete, and the company wants to be able to have the newest model without having to sell the old asset and purchase the latest one.
For example, some technology assets are quickly replaced with newer technology. If a company has short-term leases in place, then it can return the old equipment and lease the latest technology at the end of each lease term.
the lessee will:
- record the leased asset as property, plant, and equipment (identifying it as a right-of-use asset)
- record a related lease liability (called lease liability )
-depreciate the right-of-use asset over its useful life
(right of use)
-allocate the lease payments between a repayment of the lease liability (equivalent to the repayment of loan principal) and interest expense
Lease vs purchase, how do they get accounted for?
With a lease, the lessee’s accounting is the same as if it had borrowed money and purchased the capital asset. The effects on a company’s statement of financial position are identical.
(exhibit 10.4)
What Long-Term Liabilities Arise from Transactions with Employees?
- some benefits are deferred until the employees have retired
- most common example is pension plans, but there are other post-employment benefits, including health care, dental benefits, and life insurance
Types of pension plans
1) Defined Contribution
2) Defined benefit
3) Hybrid pension plan
defined contribution pension plan (definition)
A pension plan that specifies how much a company will contribute to its employees’ pension fund.
- No guarantee is made of the amount that will be available to the employees upon retirement.
- Usually set as a percentage to of employees’ salary
- usually managed by a trustee
- not reported on the company’s statement of financial position
trustee
In the context of pension plans, an independent party that holds and invests the pension plan assets on behalf of a company and its employees
The entries to recognize the pension expense and the related payment are as follows: (accounts)
Pension Expense XXX
Pension Obligation XXX
Pension Obligation XXX
Cash XXX
Defined Benefit Pension Plans
A pension plan that specifies the benefits that employees will receive in their retirement. The benefits are usually determined based on the number of years of service and the highest salary earned by the employee.
EMPLOYERS BEARS RISK
vested benefits
the pension benefits purchased with their contributions and those purchased with the employer’s contributions belong to the employees, even if they leave the company
actuary
A professional trained in statistical methods who can make detailed estimates of pension costs
accrual entry
In the context of pension accounting, the journal entry to record the pension expense and create the pension obligation
Funding entry
The journal entry made to show the cash payment made to the trustee of a pension plan to fund the obligation
underfunded
A pension plan in which the value of the plan assets is less than the amount of the projected benefit obligation.
Fully funded
A pension plan in which the value of the plan assets equals the amount of the projected benefit obligation
overfunded
A pension plan in which the value of the plan assets exceeds the amount of the projected benefit obligation
Hybrid pension plans (aka target benefit plans)
A pension plan combining features of defined contribution and defined benefit plans, which establishes targeted benefit levels that are funded through fixed contributions by both the employer and employee.
With hybrid pension plans: (exhibit 10.5)
There are no guaranteed benefit levels, only agreed-upon benefit targets.
These targets can provide employees with better information for planning their other sources of retirement income.
post-employment benefits
Benefits other than pensions provided to retirees. These benefits are typically health care or life insurance benefits
deferred income taxes (aka future income taxes)
An asset or liability representing tax on the difference between the accounting balance of assets/liabilities at a given point in time and the tax balance of the same assets/liabilities. These differences arise when a company uses one method for accounting purposes and a different method for tax purposes.
KEY POINTS Deferred income taxes
Deferred income taxes are taxes that will come due in the future.
These are not taxes that are payable to the government today.
Income Tax Act
-uses the cash basis of accounting for a number of items
capital cost allowance (CCA)
The deduction permitted by the Canada Revenue Agency for tax purposes, instead of depreciation
How Are Contractual Commitments and Guarantees Reflected in the Financial Statements?
These can include commitments to purchase certain quantities of raw materials at certain prices, operating lease commitments, utility contracts, fixed labour rates on maintenance contracts, and the like
mutually unexecuted contracts
A contract between two entities in which neither entity has performed its part of the agreement
commitments (aka contractual commitments)
Obligations that a company has undertaken that do not yet meet the recognition criteria for liabilities. Significant commitments are disclosed in the notes to the financial statements
Provisions
- liabilities for which there is uncertainty with respect to timing or amount
- They included arrangements such as estimated warranty claims, estimated sales returns, and customer loyalty arrangements
contingent liabilities
A liability that is not recorded in the accounts, because it depends on a future event that is not considered probable and/or cannot be estimated reliably. Significant contingent liabilities are disclosed in the notes to the financial statements
leverage
the extent to which a company is using the funds provided by creditors to generate returns for shareholders
-it means a company is trying to make money for its shareholders by using the creditors’ money
Two ratios for leverage
debt to equity ratio
net debt as a percentage of total capitalization ratio
interest-bearing debt
debt on which the company is required to pay interest, such as loans, mortgages, and bonds payable
Net debt
name given to the amount of interest-bearing debt less the amount of cash or cash equivalents that a company has available
debt to equity ratio measures
the extent of debt relative to each dollar in equity
How Are Contractual Commitments and Guarantees Reflected in the Financial Statements?
These can include commitments to purchase certain quantities of raw materials at certain prices, operating lease commitments, utility contracts, fixed labour rates on maintenance contracts, and the like
mutually unexecuted contracts
A contract between two entities in which neither entity has performed its part of the agreement
commitments (aka contractual commitments)
Obligations that a company has undertaken that do not yet meet the recognition criteria for liabilities. Significant commitments are disclosed in the notes to the financial statements
Provisions
- liabilities for which there is uncertainty with respect to timing or amount
- They included arrangements such as estimated warranty claims, estimated sales returns, and customer loyalty arrangements
contingent liabilities
A liability that is not recorded in the accounts, because it depends on a future event that is not considered probable and/or cannot be estimated reliably. Significant contingent liabilities are disclosed in the notes to the financial statements
Possible obligations arising from past events
leverage
the extent to which a company is using the funds provided by creditors to generate returns for shareholders
-it means a company is trying to make money for its shareholders by using the creditors’ money
Two ratios for leverage
debt to equity ratio
net debt as a percentage of total capitalization ratio
interest-bearing debt
debt on which the company is required to pay interest, such as loans, mortgages, and bonds payable
Net debt
name given to the amount of interest-bearing debt less the amount of cash or cash equivalents that a company has available
debt to equity ratio measures
the extent of debt relative to each dollar in equity
Debt to Equity =
(equation)
debt-to-equity ratio
Net debt / Shareholders equity (net is not the same as total, nor is average)
OR
Interest-bearing debt - cash / Shareholders equity
Interest-bearing debt includes
bank loans (both current and non-current) and notes payable
net debt as a percentage of total capitalization ratio measures
the proportion that debt makes up of a company’s total capitalization; that is, what percentage debt represents of the company’s total financing
Net Debt as a Percentage of Total Capitalization =
equation
Net debt / Total Capitalization =
Interest-bearing debt - cash /
Shareholders equity + interest-bearing debt - cash
interest coverage ratio (aka times interest earned ratio)
A measure of a company’s ability to meet its interest obligations through its earnings; that is, the company’s ability to generate enough income from operations to pay its interest expense. It is calculated as the earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by interest expense
earnings before interest, taxes, depreciation, and amortization (EBITDA)
The amount of a company’s earnings before interest, taxes, depreciation, and amortization are deducted
Interest coverage =
equation
EBITDA / Interest Expense
Interest Coverage measures
the number of times a company’s earnings could pay its interest expense.
The higher the number, the less risk there is of the company being unable to meet its interest obligations through earnings. (high = good)
If, after the first year of a pension plan’s operation, the amount of the employer’s accrual entry for that year is greater than the amount of its funding entry, the plan is said to be
UNDERFUNDED! !!
More = underfunded Less = overfunded
A long-term lease for equipment will normally result in
_______ expense being recorded on the lessee’s books.
INTEREST
The most common example of a contingent liability is when
a company has been named in litigation
This could mean it is being sued by a customer for breach of contract, by a competitor for patent infringement, and so on
Lawsuit
- There is uncertainty about whether there is, in fact, an obligation of the company and this uncertainty will be…
Whether or not the company will have a liability will depend upon the outcome of the litigation
Usure now if they will win or lose the cae, if they win then they no liability is paid, if they lose then a major liability may be apparent, depends on the results of case
Lawsuit
- It is not considered probable that an outflow of resources representing economic benefits will be required to settle the obligation.
A company’s legal counsel may consider it unlikely that the lawsuit will result in any economic outflow, either because the company will win its case or the outcome is unlikely to result in material economic outflows
The payment may not be money, and the case may not be won against them
Lawsuit
- The amount of the obligation cannot be reliably measured.
A company’s legal counsel may be unable to estimate the potential outcome because there have been no precedents related to the subject of the lawsuit or because the range of possible settlements is very broad.
Who knows how much the lawsuit demands, and if a very rare case with no prior cases of this sorts, there is no reference point to guess payout price
From the perspective of a shareholder,
a higher degree of leverage is normally preferable to a lower one.
from the perspective of a lender (or potential lender),
then a lower degree of leverage is considered to be better
Which statement is true?
When a company’s taxable income is lower than its accounting income due to temporary differences that will reverse in future years, it will record a deferred tax liability.
Note disclosure for contingencies should include
the estimated timing of the economic outflows of resources.
the possibility of future reimbursements.
management’s assessment of the uncertainties related to the amount.
A four-year, 5%, $40,000 note payable is issued on January 1st to purchase land. Terms for the note include fixed annual principal payments of $10,000, plus interest on the outstanding balance. The entry to record the first installment payment will include a
debit to the Interest Expense account of $2,000.
Which of the following statements is true? Select all that apply.
The annual expense to an employer with respect to its defined-benefit pension plan is difficult to calculate and can vary from year to year.
The liabilities of a defined-benefit pension plan represent the present value of future pension obligations to be paid to the plan’s members during their retirement.
The net debt as a percentage of total capitalization ratio differs from the debt-to-equity ratio by adding net debt to the denominator (differs)
True
